Using asset-based financing to optimise the capital structure
Through June 2018, the total amount of dry powder within global private equity stood at USD1.09 trillion; a vast sum, up from USD1.03 trillion at the end of 2017 according to Preqin.
This makes for compelling headlines and has fuelled interest in private equity, to the extent that it has become arguably the most important alternative investment asset class. But in some ways, this volume of dry powder has become a double-edged sword; great news for managers launching new funds, but how to put this capital to work effectively?
Pierre Vinci (pictured) is Head of Origination, Asset Based Finance, ABN AMRO Corporate and Institutional Banking. Vinci oversees a 10-strong team who originate and execute transactions in the middle market, lending anywhere from EUR10 to EUR150 million to corporates and PE fund sponsors alike.
In Vinci’s view, PE managers are under pressure to deploy committed capital, including those running private debt funds.
“We’ve had a number of enquiries from private debt funds wishing to exit positions they’ve taken by refinancing with our asset-based lending team. The reality is these managers have overstretched themselves by lending to businesses that perhaps they shouldn’t have, because they are under pressure to put money to work.
“This pressure cooker environment has built up over recent years as the amount of dry powder has risen, and some people have taken bad positions in their funds. Until there is another financial crisis, we won’t be able to determine how bad things are,” comments Vinci.
With the capital markets awash with money, debt multiples are rising. In the US, on average deal multiples are 12.5 times EBITDA if one were to buy private companies, according to Pitchbook. In Europe, those deal multiples are likely to be similar.
“Current macro-economic data shows that leverage multiples are the highest they’ve ever been,” suggests Vinci. “Still, when you look at PE deal multiples compared to valuations in the public markets, they are lower. So it’s still worthwhile going the PE route for a buyer because the companies are cheaper compared to the public markets.”
Whilst some PE capital is being invested, sending multiples higher as managers compete for deals, there remains a lot of un-invested capital unable to find the right home. Sponsors are exercising restraint with respect to secondary buyouts as they cannot add as much value. More surprisingly, they struggle to invest in some other privately owned mid-market businesses that could benefit from PE ownership.
Vinci remarks that whereas in the US economy, PE ownership accounts for around 1.5 per cent of total GDP, in Europe it barely climbs above 0.5 per cent of total GDP.
“The middle markets in Europe’s largest economies represent in the region of 30 per cent of their respective GDPs, yet PE ownership is 0.5 per cent so you can see there is huge untapped potential.
“There are still many family-owned businesses in countries like France, Germany or Italy that have yet to make it to the next stage of their growth. They have good banking relationships but this doesn’t necessarily help them strategically. They would benefit from private equity financial support and expertise. Yet, their reluctance to relinquish control means they often don’t take that step.
“So on the one side there is a huge amount of dry powder that needs to be deployed, while on the other side there remains a lack of private equity penetration. It’s difficult to reconcile these two factors unless, over the next few years Europe follows the same trend as the US and more institutional capital flows in to private markets,” argues Vinci.
The area that Vinci and his team cover, lending against the assets of companies with sometimes lower quality credit, does not tend to attract PE sponsors wishing to overly leverage. On average, 30 to 50 per cent equity is used for acquisitions.
“Given the nature of these companies, if a private equity sponsor buys it knowing there will be too much debt to repay at a critical time of the company’s lifecycle, it’s going to make things worse. They need to give these companies time to improve their fortunes, and that means making sure the balance sheet is not burdened with too much debt on day one,” remarks Vinci.
He says that ABN AMRO is keen to provide financing solutions to companies that need high levels of working capital and investment in plant equipment, for example, operating in lower margin cyclical sectors such as industrial, manufacturing and packaging.
“When there’s a high level of Capex, a cashflow financier might look at a company negatively because it bites into the EBITDA whereas we like Capex because we provide asset-based finance.
“We can also offer flexibility on leverage. If it’s an off-balance sheet structure we can provide leverage indirectly by buying receivables against cash through a receivables purchase structure, which is helpful for GPs looking to optimise the balance sheet or financial ratios before a potential sale of the business, or for their financial reporting for example.
“We can also provide a higher than usual level of leverage by providing a revolver against current assets, namely receivables and stock, alongside a term loan against fixed assets. Whereas typical leverage from traditional cashflow finance might struggle to go past 6 times, we can offer beyond that level for asset-rich businesses,” says Vinci.
Companies use revolvers for short-term financing needs to cope with periods of negative earnings or cover operating expenses, for example.
Increasingly, ABN AMRO’s asset based finance team is partnering with fund sponsors to provide what Vinci refers to as a FILO structure – first in last out.
This structure is a good alternative to the more traditional unitranche model. It offers a hybrid structure which combines senior and subordinated debt and applies a blended interest rate.
Vinci says they’ll work with a fund – often one that specialises in asset based lending – by combining a revolver against the company’s current assets with a term loan against the fixed assets which will maximise debt capacity by funding assets up to 100 per cent advance rate.
“The advantage, compared to using a unitranche, is that you don’t end up with a large term loan on day one, which you are paying a full interest rate on throughout its term. You get a smaller term loan on the piece of the business against which you need to draw capital and then a larger revolver that acts as a more flexible and cost effective component.
“Our blended price is lower than a unitranche; it could be as much as 2 to 3 per cent, which is quite a lot in respect to the EBITDA margin.
“It doesn’t apply to all companies but for those with a strong asset base, such a funding solution is worthwhile for GPs to consider,” concludes Vinci.